Important legal information about the email you will be sending. By using this service, you agree to input your real email address and only send it to people you know. It is a violation of law in some jurisdictions to falsely identify yourself in an email. All information you provide will be used by Fidelity solely for the purpose of sending the email on your behalf. The subject line of the email you send will be "Fidelity.com: "

Measured by volume alone, this summer’s stock market has been in the doldrums. But price action has hardly been calm, thanks to turbulence in Turkey, major volatility in several leading tech stocks, and more central bank tightening on the horizon. With that said, the underlying force driving markets, including the US, has been persistently strong corporate earnings, helping drive stock prices back toward the top of their charts.

If you like using charts to supplement your fundamental analysis of investment ideas, consider Dow Theory—the foundation of technical analysis created by Charles Dow, cofounder of the Wall Street Journal and the Dow Jones Industrial Average. Key elements of Dow Theory now suggest stocks may be poised to go higher, though one key ingredient is missing from this indicator saying the market might really start cooking.

Dow Theory primer

Much of technical analysis—the method that attempts to find patterns and trends based on market behavior and investor psychology—derives from Dow's findings that markets move in trends. Dow, who died in 1902, used the analogy of the ebb and flow of tides to describe how the market acts. He believed that stocks move in trends, similar to how waves crash onto the beach, and leave patterns in the sand to show where high and low tides occurred. If you can use these patterns to identify the direction of market trends, you may be able to better position your portfolio.

When Dow was researching the market in the late 1800s, there were far fewer stocks, and indexes were not as commonly used as they are now. Dow created 2 indexes, or averages, as they are referred to in Dow Theory: Industrials and Transportation (also known as Transports). These averages served as the basis for his analysis of primary and secondary trends.

The market moves in waves and trends, and a trend is assumed to exist until evidence suggests it has reversed.

Volume must confirm the trend.

Dow believed that markets are forward-looking and that past price movements can help discern probable future price trends. This is the crux of all technical analysis. Chart analysts believe that Dow Theory presents an opportunity to step back from the day-to-day fluctuations of the market and help understand longer-term primary trends.

Dow theory in action

If there is one critical application of Dow Theory to know about, it is thatthe averages must confirm one another. Dow was referring to the Dow Jones Industrial Index and the Dow Jones Transportation Index.

Before the financial crisis, the averages did not confirm new highs, signaling a potential Dow Theory reversal.

Source: FactSet, as of August 8, 2018.

For example, suppose that during a bull market rally the Transports made a new relative high (a price that is higher than recent data) but the Industrials did not. That the averages did not confirm one another (both did not make new relative highs at roughly the same time) may indicate that a reversal of the trend could be on the horizon. Consequently, Dow Theory suggests that both averages could fall below a significant support level.

Not only did Dow believe that the movements of the 2 averages (Industrials and Transportation) must confirm each other, he also thought that volume must confirm the trend. Volume confirmation is an indicator that can apply to any investment. For example, if a stock rises and volume rises (relative to a recent time frame, say, the past several weeks or months), that means volume has confirmed the uptrend. Similarly, if a stock declines and volume rises, that means volume has confirmed the downtrend. Dow assumed an existing trend to be in place until clear signals, confirmed by volume, indicated that it has reversed.

The principles of Dow Theory laid the foundation for much of the short- and long-term technical tools and chart patterns that have followed Dow's work.

Dow Theory now says...

The first thing that should be apparent in the 1-year chart below of the Dow Jones Industrial Average and the Dow Jones Transportation Average is the long-term primary uptrend for US stocks. While there was a sharp correction in early 2018, followed by a multi-month period where stocks moved mostly sideways, stocks have resumed their uptrend more recently.

Over the past month or so, both the Industrials and Transports have been making higher lows and higher highs—a bullish signal according to Dow Theory. Of note, there was a moderate correction in July that pushed both averages lower than prior lows. Yet the Industrials and Transports have made several higher highs since then, including in early August where stocks have moved within striking distance of their record highs set in January 2018.

Dow Theory using the Industrials and Transports

With that said, volume for both averages has been low relative to prior months—as the Dow Jones Industrial Average volume depicted on the bottom of the chart reveals. Recall that Dow believed volume must confirm the trend. Thus, while the averages have confirmed one another’s uptrend, volume has not increased commensurately.

If volume picks up, as it historically does when the calendar turns from August to September, and the averages continue to confirm one another’s uptrend, that would be a buy signal, according to Dow Theory. If volume does not increase relative to its current level, along with the averages making higher highs and higher lows, this would be a sign that the market may not continue to move higher. (Note: Due to the seasonal nature of market performance, it is often useful to compare similar time frames when assessing volume trends).

Stocks are reapproaching all-time highs, so chart users have a key price resistance level that can be used as a bellwether to gauge if the market has the strength to rise further. In sum, Dow Theory suggests US stocks have potential upward momentum, but caution is warranted.

A last point about Dow Theory

Critics of Dow Theory (and of technical analysis in general) might say that price behavior alone is not sufficient information on which to base an investing decision. Additionally, Dow Theory relies on 2 indexes that have changed composition dramatically since the theory was created more than 100 years ago.

That's why active investors would be wise to bolster their use of Dow Theory with other tools and methods, including fundamental analysis, to help identify trends and potential changes in trends. Nevertheless, Dow Theory, created by the father of technical analysis, can be one of many resources at your disposal.

Important legal information about the e-mail you will be sending. By using this service, you agree to input your real e-mail address and only send it to people you know. It is a violation of law in some jurisdictions to falsely identify yourself in an e-mail. All information you provide will be used by Fidelity solely for the purpose of sending the e-mail on your behalf.The subject line of the e-mail you send will be "Fidelity.com: "

Technical analysis focuses on market action — specifically, volume and price. Technical analysis is only one approach to analyzing stocks. When considering which stocks to buy or sell, you should use the approach that you're most comfortable with. As with all your investments, you must make your own determination as to whether an investment in any particular security or securities is right for you based on your investment objectives, risk tolerance, and financial situation. Past performance is no guarantee of future results.

Past performance is no guarantee of future results.

The views expressed are as of the date indicated and may change based on market or other conditions. Unless otherwise noted, the opinions provided are those of the speaker or author, as applicable, and not necessarily those of Fidelity Investments. The experts are not employed by Fidelity but may receive compensation from Fidelity for their services.

These comments should not be viewed as a recommendation for or against any particular security or trading strategy. Views and opinions are subject to change at any time based on market and other conditions.

Stock markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. Investing in stock involves risks, including the loss of principal.

Votes are submitted voluntarily by individuals and reflect their own opinion of the article's helpfulness. A percentage value for helpfulness will display once a sufficient number of votes have been submitted.